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Institutional Constraint

This note was originally published at 8am on July 28, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“We have many constraints as investors.”

-Seth Klarman


Baupost’s Seth Klarman is no stranger to going to cash. Neither is he shy about telling it like it is about how the game of Institutional Asset Management works. The aforementioned quote has nothing to do with the self-directed individual investor. It has everything to do with Institutional Constraints.


“Constraint”, per Wikipedia, “is an element factor or a subsystem that works as a bottleneck. It restricts an entity, project, or system from achieving its potential with reference to its goal.” Institutional Constraint isn’t what Klarman calls it, but I think he’d agree.


In Grant’s back in Q1, Klarman said “we want short-term performance, and are measured by this. There is enormous pressure from clients for short term performance. Mutual funds compete in a relative space. What’s important is absolute returns. The way people do this is forced mediocrity. To do absolute performance, you have to bet against the crowd sometimes.”


Sometimes betting against the crowd too early makes an investor wrong. Sometimes betting against your current positioning can make you less wrong. In a market like this, where Institutional performance chasing is one of the most misunderstood long-term TAIL risks we’re observing, price levels matter – big time. So does considering them on a multi-factor, multi-duration basis.


What does multi-factor mean?


First, let me tell you what it doesn’t mean:

  1. Point and click 1 factor models of simple moving averages (50 day, 200 day, etc)
  2. Being sucked into the Sentiment Vacuum of 1 topic (Debt Ceiling is the #1, #2, and #3 most read on Bloomberg this morning)
  3. Considering Global Macro risk from the vantage point of 1 country and/or 1 asset class (“what’s the Dow doing?”, c’mon)

Within the construct of Chaos/Complexity Theory (my modern day market practitioner’s answer to stale academic Keynesian Dogma), multi-factor is as multi-factor does. You need to build a risk management process that absorbs multiple price, volume, and volatility signals, across multiple asset classes, and across multiple durations.


If I had 10 Chinese Yuans for every person I’ve met in this business who says “well, the chart looks good”, I’d have a lot more money to fund Hedgeye’s growth. What, precisely, do charts mean? The answer to that is as simple as the deep simplicity Chaos Theory aspires to achieve. The chart looks as good as the math you have embedded in the picture!


If bells weren’t going off in your Global Macro Risk Management Process yesterday, I suggest you get a new one. Here are some of the alarms going off in mine that had me take my Cash position back up to 46% from 37% (where I started the day):

  1. EUROPE – both European stocks and bonds are turning into a proactively predictable train wrecks. Our research catalysts remain crystal clear (accelerating debt maturities for the majors through September) but, more importantly, now all of our TRADE and TREND lines across every major European stock and bond market (ex-Russia) have been broken and confirmed by volume and volatility studies.
  2. USA – stocks broke their intermediate-term TREND line of support (1320 in the SP500) and short-term bond yields finally busted a move above my 2-year yield TRADE line of resistance (0.41%).  Credit risk derived by market morons in Congress will be priced on the short-end of the curve (where Bernanke has tried to mark it to model for 2 years), so watch that 0.41% line like a hawk.
  3. GLOBALLY – China’s Shanghai COMP TREND line = 2831 (broken); India’s BSE Sensex TREND line = 18,578 (broken); German DAX TREND line = 7251 (broken); FTSE TREND line = 5985 (broken); SP500 TREND line = 1320 (broken); Russell2000 TREND line = 827 (broken); WTIC Oil TREND line = 103 (broken); EUR/USD TREND line = $1.43 (schizophrenic).

No one at Hedgeye has ever said 2011 Global Growth or 2H2011 Earnings Expectations were priced properly. If you close your eyes to all of my quantitative and research factoring across asset classes and just focus on those 2  - they are VERY large fundamental factors to consider having market impact above and beyond these yahoos in Congress.


Look, I’m not saying I got all of this right. What I am simply saying is that we, as a profession, can get a lot better at this if we just open our minds to re-thinking risk and re-working our asset allocations as the big factors are changing. The market doesn’t care about our respective investment styles, compensation mechanisms, or Institutional Constraints.


My immediate-term ranges for Gold, Oil, and the SP500 are now $1603-1624, $96.03-100.32, and 1298-1316, respectively. I cut my US Equity exposure to 3% (from 9%) in the Hedgeye Asset Allocation Model yesterday.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Institutional Constraint - Chart of the Day


Institutional Constraint - Virtual Portfolio




TODAY’S S&P 500 SET-UP - August 1, 2011


Large bond fund managers who bet on US “credit risk” are either unwinding that theme or need to now – across the US Treasury curve bonds are breaking out to new YTD highs and the US Dollar is strengthening, making higher-all-time lows.  As we look at today’s set up for the S&P 500, the range is 41 points or -0.93% downside to 1275 and 2.26% upside to 1316.






THE HEDGEYE DAILY OUTLOOK - daily sector view


THE HEDGEYE DAILY OUTLOOK - global performance




  • ADVANCE/DECLINE LINE: +195 (+1223)  
  • VOLUME: NYSE 1110.41 (-8.19%)
  • VIX:  25.25 +6.36% YTD PERFORMANCE: +42.25%
  • SPX PUT/CALL RATIO: 2.41 from 2.30 (4.57%)



YIELD SPREAD – one of the highest conviction  long positions we’ve had in 2011 to express our Growth Slowing theme has been a US Treasury Flattener (FLAT); the Spread b/t 10s and 2s is making a new YTD low this morn as bond yields collapse alongside awful US GDP and ISM reports.


  • TED SPREAD: 16.06
  • 3-MONTH T-BILL YIELD: 0.10%
  • 10-Year: 2.77 from 2.82    
  • YIELD CURVE: 2.39 from 2.46


  • 7:45 a.m./8:55 a.m.: Weekly ICSC/Redbook retail sales
  • 8:30 a.m.: Personal income, est. 0.2%, prior 0.3%
  • 8:30 a.m.: Persona spending, est. 0.1%, prior 0.0%
  • 11:30 a.m.: U.S. to sell $23b 4-wk bills
  • 4:30 p.m.: API inventories


  • McGraw-Hill reiterated it was reviewing its portfolio after holder Jana Partners said it had discussions with co.
  • U.S. light-vehicle delivers in July, to be released later today, may have run at 11.8m seasonally adjusted annual rate, trailing the 12.5m rate in 1H, analysts’ estimate



OIL – it may have been out of the headlines, but that doesn’t mean its daily price/volume/volatility signals cease to exist; with the USD strengthening, WTIC oil has broken its TRADE line of support ($96.21) this morning and that matters since Energy is literally the only S&P Sector left that’s bullish in US Equities on both TRADE and TREND durations


THE HEDGEYE DAILY OUTLOOK - daily commodity view




  • Gold Advances to Near Record as Slowing Growth Increases Demand
  • Sugar Falls for Fifth Day on Brazilian Exports; Coffee Rises
  • Copper May Climb as Strike Continues at World’s Biggest Mine
  • Bank of Korea Boosts Gold Holdings to ‘Reduce Investment Risks’
  • BHP Copper Miners ‘Optimistic’ on Agreement to End Chile Strike
  • Wilmar Says to Raise Cooking Oil Prices in China by About 5%
  • Coffee Seen Rising 10% in Two Months as Vietnam Delays Exports
  • Mining Takeovers Heading for Record in 2011, Ernst & Young Says
  • Rice May Sustain Rally as U.S. Acreage Declines, Ofon Says
  • Japan Widens Cattle Shipment Ban as Tochigi Beef Contaminated
  • BullionVault Lures Most Funds Since Lehman’s Collapse on Haven
  • Barrick Says Gold to Remain High on China, India Inflation



EUR/USD – remains the currency pair that makes the world’s correlation risk go round and this morning we’ve seen another decisive break-down below our $1.43 TREND line; Europig Equities are getting slaughtered – we have no long exposure to anything European Equities; we are long USD and short EUR


THE HEDGEYE DAILY OUTLOOK - daily currency view




  • EUROPE: a royal Europig mess continues with FTSE and DAX breaking both TRADE and TREND lines as Italy and Spain collapse (stocks and bonds)
  • UK July construction PMI 53.5 vs consensus 53.0, prior 53.4

THE HEDGEYE DAILY OUTLOOK - euro performance




  • ASIA: finally breaking some critical TRADE lines of support; Nikkei and KOSPI in particular down hard through lines that matter last night.
  • Australia June residential building approvals (3.5%) vs cons +2.5%.
  • Japan June wages (0.8%) y/y.
  • Japan June monetary base +15% y/y to ¥113.73T

THE HEDGEYE DAILY OUTLOOK - asia performance








Howard Penney

Managing Director

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Repetitive Drills

“Even in his repetitive drills he had a way of making the mundane seem important.”

-David Maraniss (on Vince Lombardi)


That quote comes from an inspirational excerpt on page 212 of “When Pride Still Mattered” where David Maraniss boils down the deep simplicity of Lombardi’s coaching process. If you’re trying to lead a country, company, or family this morning, I confidently submit that consuming this perspective is well worth your time. America needs you, The People, to lead us out of this mess.


Vince Lombardi was “the football variation of a masterly novelist who could take the muddle of everyday life and bring clarity and sense to it, and allow readers to see, for the first time what was in front of their eyes all along. Bart Starr was on the edge of his seat, listening – getting it for the first time. All the crap was gone; this was right to the bone, simple, yet so refreshing and exciting.”


“Everything was accounted for, labeled, identified, put in order, fundamental and sound. You could tell that the coach believed in what he was doing. His tone of voice, his posture, his manner – it all made you believe. It all made sense.”


So let’s grind. This globally interconnected marketplace all makes sense – you just need to account for “everything”:

  1. US TREASURIES – across the curve, 2s, 10s, and 30-year UST yields are making fresh YTD lows this morning in the face of a very wrong bet by some of our industry’s losing teams that suggested there was US “credit risk” coming down the pike. Not today.
  2. US DOLLARS – had a breakout day yesterday, trading right back above an important line of immediate-term support ($74.11 on the US Dollar Index) as clarity on the “Debt Deal” found her way into the market’s currency expectations.
  3. US EQUITIES – not good folks; not good – but are you surprised? With “Debt Deal” being replaced by “Growth Slowing” in this morning’s headlines, many a macro market observer has come to realize that more than just US politics makes globally interconnected risk go round.

Perversely, since La Bernank has addicted the entire Institutional Investing Community to chasing yield, what’s good for America’s currency is quite bad, in the immediate-term, for stocks and commodities.


We’ve labeled this The Correlation Risk (USD up = stocks and commodities down). Sadly, Bernanke and Geithner have been negligent in addressing this massive tail risk to the American people when under oath.


So what do you do with that?

  1. Short the Euro
  2. Short European Equities
  3. Sell US Equity and Commodity exposure

People want “clarity” in this market place. There it is.


On yesterday’s proactively predictable opening market strength, I sold down my US Equity exposure in the Hedgeye Asset Allocation Model to 0%. That’s ZERO. Like my long exposure to European Equities – ZERO.


As of yesterday’s close, here’s how the Hedgeye Asset Allocation Model is positioned:

  1. Cash = 52% (up from 43% last week)
  2. Fixed Income = 18% (Long-term Treasuries and US Treasury Flattener – TLT and FLAT)
  3. International Currencies = 12% (US Dollar and Canadian Dollar – UUP and FXC)
  4. International Equities = 12% (China, India, and S&P International Dividend ETF – CAF, INP, and DWX)
  5. Commodities = 6% (Silver – SLV)
  6. US Equities = 0%

Now the Hedgeye Portfolio (14 LONGS and 12 SHORTS) is a different product obviously than long-only asset allocation. Neither of these products are perfect. No one’s risk management process in this business ever will be. We get that – but every move we make is based on a repeatable process that changes as the math does. And, believe me, the coach over here believes in what he is doing.


My goal is simple. I want to win. And my team will stand here alongside you on the front lines of Global Macro market risk, just as we did during the thralls of 2008, so that you don’t lose your hard earned net wealth. We don’t make excuses. We make moves.


Since January 2011, we have led the debate that Global Growth Slowing was going to equate to lower than expected US Equity returns. Every morning since, we have been banging the drums with our often Repetitive Drills to remind you what we are seeing and when.


That doesn’t mean I am going to own US Treasuries (TLT), Flatteners (FLAT), or Silver (SLV) forever. I could sell them all today and nothing will have changed unless I deviate from the process in order to make those decisions. If the process changes, I better know why. And I damn well better be able to explain it to my troops.


In a world where people have no reason to believe their country’s leaders…


In a world where politics trump objectively scored performance…


That’s the best we can do as leaders. We have to be accountable. We have to make sense.


My immediate-term support and resistance ranges for Gold, Oil, and the SP500 are now $1611-1637, $94.11-96.21, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Repetitive Drills - Chart of the Day


Repetitive Drills - Virtual Portfolio


EPS came in at $0.22 versus $0.23 consensus.  The top-line numbers, as we expected were strong, but margins were weaker-than-expected and guidance for full-year EPS growth was as margin pressures were brought to bear on the company’s P&L.  As we wrote this afternoon, there are other companies that we would prefer on the long side in casual dining, particularly given what we view as a lofty multiple for what TXRH offers investors.


Below is our Top Ten Takeaways from the quarter:

  1. The company’s top-line is healthy.  Two-year average trends accelerated sequentially in the second quarter and accelerated in July versus the 2Q number also.  For the first four weeks of the third quarter, comps were reported as +3.9%.
  2. Following a (average system) price increase of 1% in March, a further 1% (average) price increase has been taken to bring the store base up to 2% pricing on the menu.  Despite this, traffic has remained strong and the comp overall, as pointed out above, seems to be improving through July.
  3. Later this month, the company will test an additional price increase of just over 2% at 19 locations.  If successful, the hike could be rolled out system-wide next year if food costs remain at elevated levels.
  4. Despite this impressive top-line performance the comp growth has not been sufficient to offset the significant margin pressure brought on by commodity and labor costs.
  5. The company expects continuing deleveraging on the labor line due to new restaurant labor costs and higher investment in labor hours.
  6. The primary items that boosted the company’s cost of sales were proteins, cooking oil, butter, potatoes.
  7. The company anticipates increased inflationary costs, particularly around proteins, in 2012.
  8. New unit growth is set to accelerate in 2012 with 25% growth in unit openings versus the projected 20 company restaurant openings in 2011.
  9. This stock was priced for near perfection with a lofty EV/EBITDA multiple and, upon not delivering just that, is selling off sharply post-market.  We do not expect this to be the last stock to do so this earnings season.
  10. Sell-side sentiment is certainly not bearish with zero sells on the stock and ~60% of analysts rating it a “Buy”.  There is plenty of room for sentiment to swing.

TXRH: (NARROW) MISS AND LOWER - txrh sell side sentment



Howard Penney

Managing Director


Rory Green



Conclusion: Growth in Japan is setup to slow meaningfully in 2H as a result of regulatory uncertainty, anti-growth legislation, and a good ol’ fashioned lack of enough demand to surmount increasingly tough comparisons. Moreover, we expect the BoJ to intervene in the FX market not too far beyond current growth-negative levels in the JPY/USD exchange rate.


Position: Short Japanese equities (EWJ); Short the Japanese yen (FXY).


Amid an unsurprising bout of legislative gridlock and proactively predictable, broad-based sequential accelerations in economic growth data, we’ve been quiet on Japan in recent weeks. Now, with a growing spate of “uncertainty” enveloping the global economy, we find it appropriate to revisit the secular trends we have identified within the context of our Japan’s Jugular thesis.  Moreover, the research and risk management setups support being short Japanese equities and Japan’s currency, the yen. We identify levels and a few key catalysts below.


Regulatory Uncertainty is Depressing Growth

The hullabaloo around Prime Minister Naoto Kan’s eventual resignation continues to prevent the Japanese government from functioning at full speed; so much so that the Diet has yet to ratify legislation authorizing the issuance of ¥44.3 trillion ($575B) more JGBs to finance the FY11 budget – which began back at the start of April! The Ministry of Finance warns that they’ll have to begin restricting implementation of the budget as early as late September without a resolution of Japan’s own debt ceiling debacle. Much like in the U.S., we expect legislation to eventually be passed in time to avoid default; we also expect continued brinksmanship to weigh on consumer and corporate sentiment that has otherwise been steadily accelerating off the March/April lows. Barring a second extension, Japanese lawmakers have until the end of this month to figure it out (the current Diet session adjourns on September 1st).


Regarding the reconstruction effort, DPJ lawmakers have confirmed that the Japanese government plans to spend a total of ¥19 trillion ($246B) over the next five years to fund public disaster recovery efforts. Via two recent bills totaling ¥4 and ¥2 trillion apiece, as well as an additional ¥3 trillion in savings, ¥9 trillion of the total requirement has already been secured. This leaves an additional ¥10 trillion which is likely to be financed with higher taxes, according to official sources. A panel of the prime minister’s top economic advisors has suggested doubling the consumption tax to 10%, though the party remains reluctant to proceed with their suggestion, given that the last increase in 1997 sent the permanently-fragile economy into a recession.  Raising the income tax and/or corporate taxes also remain viable outcomes.


Regardless of avenue, we see any moves by the Diet to raise taxes to this magnitude as incrementally bearish for Japanese growth over long-term tail, as the ever large government (deficit = 10.7% of GDP in FY11; debt = 212.4%) continues to swallow the economy whole. Nevermind the reconstruction story, even prior to the earthquake/tsunami, the Finance Ministry had already officially proposed that the consumption tax be doubled by “at least the middle of the decade” to cope with fast-rising social security costs (~30% of total expenditures). Public rebuilding efforts only speed up the timeline and increase the magnitude by which anti-growth fiscal policy must be implemented over the long term.


Uncertainty surrounding future energy policy is also slowing Japanese economic growth on the margin. Energy reform, which is the second of the two remaining pieces of legislation that Naoto Kan must see passed prior to resigning (the deficit-financing bond bill is the other), remains a key topic of contention in Japan and supports our view that Kan might remain in charge well into 2012 – despite his lowly 17.1% approval rating. Kan seeks to have Japan procure 20% of its energy needs from renewable energy by 2020 – up from around 1% currently. No details have been given surrounding how the world’s most heavily indebted sovereign entity plans to pay for such a broad-sweeping initiative.


The uncertainty here is a negative near-to-intermediate-term catalyst because it: a) potentially delays the timeline by which Japan’s nuclear plants come back online (currently 38 of Japan’s 54 reactors are either idle or offline); and b) it casts uncertainty amid Japanese manufacturers on whether or not Japan will have enough power supply to meet their production plans over the long term. Such ambiguity is already weighing on corporate decisions to invest in Japan, as a recent Cabinet Office survey shows the percentage of goods Japanese manufacturers plan to produce outside of the Japan by 2015 jumped +340bps YoY to 21.4%.


This secular shift would be incrementally exacerbated if Japan has any hiccups meeting its energy needs over the next 6-12 months as planned blackouts force consumers and corporations to slow energy use. According to Bloomberg calculations, 40 of Japan’s 54 reactors will be offline undergoing scheduled maintenance in August and it remains to be seen if the political will is there to quickly bring them back online. We’ve already seen Japan’s unemployment rate tick up +10bps in June to 4.6% - a noticeable and meaningful increase, given that Japan’s ever-dwindling working age population keeps an artificial and deceptive lid on Japanese unemployment statistics.


All told, the combination of fiscal and energy policy uncertainty and the likelihood that any resolutions are likely to take the shape of anti-growth policy have us bearish on Japan’s economic growth over the intermediate-term TREND and long-term TAIL. Broken from a TRADE perspective, we think that Japanese equities are starting to reflect this reality while the incredibly consensus storytelling about “cheap valuations” and “reconstruction” falls to wayside of underperformance.


Our models point to a measured deceleration in Japanese YoY GDP growth in 2H and the fundamental setup supports that conclusion. Moreover, we expect the recent trend of accelerating sequential growth (MoM; QoQ) to come to an abrupt end shortly, as nearly 2/3rds of the lost manufacturing capacity resulting from the March/April disasters has come back online already in just three short months. The current risk management setup suggests investors are giving the Japanese equities the benefit of the doubt – at least for now.






Bank of Japan Intervention

At the current 77.09 per U.S. dollar and recently as low as 76.76 on a closing basis, the Japanese yen is once again in crisis territory for Bank of Japan (BoJ) officials. In fact, their latest Tankan Survey of 1,472 exporters show that Japanese corporations are, on balance, forecasting the yen to average 82.59 per dollar this fiscal year, which ends on March 31st2012. Since the fiscal year began back on April 1st, the JPY/USD exchange rate has averaged 80.96 – a full 2% above corporate expectations. As further strength in the yen begins to depress corporate confidence and profit growth, we expect the BoJ to take matters into their own hands by unilaterally selling yen in the FX market, just as they did late last summer (¥2.12 trillion from Aug. 28ththrough Sept. 28th).




As such, we have elected to front-run the BoJ by shorting the FXY this morning. Recent policymaker commentary supports our view here: Governor Masaaki Shirakawa said last week that, “[the strong yen] could have adverse effects on the economy as a whole through a decline in exports and corporate profits, as well as a deterioration in business sentiment when appreciation is caused by uncertainties about overseas economies”. To the latter point on sentiment, recent data shows that the cash holdings of Japanese corporations hit yet another high in 1Q (up +7.1% to ¥211.1 trillion) and we would expect to see further upside here as the strong yen weighs on intermediate-term profit forecasts. Additionally, Shirakawa affirmed comments made by deputy governor Hirohide Yamaguchi the week prior in saying that the BoJ would take “appropriate actions as necessary”.




All told, we don’t ever find Big Government Intervention necessary and would prefer to let free markets reflect their fundamentals. Given that free markets have all but gone extinct, however, we’ve chosen to front-run the BoJ by shorting the yen in our Virtual Portfolio for a TRADE. Game Policy or be gamed yourself.


Darius Dale


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.